Plastic Surgeon's Share Of LLC Income Not Subject To Self-Employment Tax

In Hardy v. Commissioner, the Tax Court considered the self-employment tax consequences of a plastic surgeon’s share of income earned through his investment in an LLC that owned and operated a surgery center. Whether a professional’s share of a pass through’s income is subject to self-employment (SE) tax is an important issue that affects many taxpayers. In Hardy, the taxpayer successfully argued that his share was more like passive income and was not subject to SE tax. In this post I will briefly discuss the issue and the reason for the Tax Court finding in favor of Dr. Hardy.

In that post I compared and contrasted self-employment tax consequences of using an S Corp and other pass through entities. Limited partners, like shareholders in an S Corp, are generally shielded from self-employment income on partnership profits. That is because Section 1402(a)(13) excludes from the definition of self-employment income the distributive share of limited partners’ income, other than a guaranteed payment for services. Section 1402(a)(13) predates the explosion of other pass through entities like LLCs that allow members, unlike limited partners, to actively participate in the business of the entity while also providing in some ways for liability protection.

There has been uncertainty regarding how that income should be characterized. Naturally, taxpayers have analogized members in these entities to limited partners for self-employment tax purposes; IRS, with some success, especially when the members were active in the business that generated the service income, generally treats the members’ share of the entity’s income as net business income subject to self-employment tax. The key, at least from the Tax Court’s perspective, is to determine whether the income that the member receives is more related to the capital investment in the entity or the services that the members perform in their capacity as individuals.

When the income seems more connected to the services that the members perform it is treated as self-employment income. The 2011 Tax Court case Renkenmeyer v. Commissioner, involving partners in a law firm is instructive. In that case the Tax Court concluded that because the “revenue was derived from legal services performed by the partners in their capacity as partners, they were not acting as investors in the law firm.”

In Hardy v. Commissioner, decided this past week, the Tax Court distinguished Renkenmeyer. Hardy was a plastic surgeon specializing in pediatric reconstructive surgery. In 2006 he purchased for $163,974 a 12.5 per cent interest in a surgery center run through an LLC. The opinion held that he did not have self-employment income on his share of the surgery center’s income. To get to its conclusion the opinion walks through Hardy’s role with the surgery center and the ways that surgeons earn income.

Hardy had no meaningful non-surgery related service responsibilities with the surgery center:

Dr. Hardy has never managed MBJ [the LLC/surgery center], and he has no day-to-day responsibilities there. Although he meets with the other members quarterly, he does not have any input into management decisions. He generally is not involved in hiring or firing decisions. His role and participation in MBJ have not changed since he became a member.

While Hardy performed some of his surgeries at the surgery center, he had no obligation to do so. The opinion discusses how patients pay surgeons directly for the surgery procedures. Patients separately pay a fee to the surgical facility for the use of facilities and associated services. What was a key fact was the nature of Hardy’s interest more closely resembled that of a passive investor, with Hardy’s share of the LLC income related to the fees patients paid for the use of the centers. In essence his cut was not explicitly tied to surgeries that he performed. Those fees were due Hardy independent of any services or surgical procedures he chose to perform at the surgery center that generated the income in question:

Dr. Hardy receives a distribution from MBJ regardless of whether he performs any surgeries at the surgery center, and his distribution is not dependent on how many surgeries he performs at MBJ. MBJ does not have a minimum surgery requirement to receive a distribution.

With that as background, the opinion distinguished Renkenmeyer and held that the income was not subject to SE tax:

Dr. Hardy is an investor in MBJ, which is distinguishable from the limited liability partnership formed by the partners in the law firm in Renkemeyer, Campbell & Weaver, LLP v. Commissioner. MBJ owns and operates a surgical center. MBJ is equipped for doctors to perform surgeries that require local and general anesthesia. MBJ bills patients for the use of the facility. Although Dr. Hardy performs surgeries at MBJ, he is not involved in the operations of MBJ as a business. In contrast to the partners in Renkemeyer, Campbell & Weaver, LLP, who are lawyers practicing law and receiving distributive shares based on those fees from practicing law, Dr. Hardy is receiving a distribution based on the fees that patients pay to use the facility. The patients separately pay Dr. Hardy his fees as a surgeon, and they separately pay the surgical center for use of the facility in the same manner as with a hospital. Accordingly, Dr. Hardy’s distributive shares are not subject to self-employment tax because he received the income in his capacity as an investor.

[notes and citations omitted]

Parting Thoughts

Hardy stands as useful precedent in the uncertain self-employment tax landscape of the treatment of members’ interests in LLCs and other pass through entities, especially for members whose income is pegged to a capital investment rather than services those members perform.

It is interesting to note that the information returns Hardy received in fact treated the income as subject to self-employment tax. This is a good reminder (as my Procedurally Taxing colleague Keith Fogg’s post Proving a Negative The Use of Section 6201(d) discussed) that preparers and taxpayers have to carefully consider the information returns starting to come in; understanding the nature of income, especially in a pass through environment, may require a bit of digging. In fact, Hardy raised this issue not in the pleadings he filed taking the case to court but only on a motion to conform the pleadings to the evidence under Tax Court Rule 41(b)(1). Hardy was fortunate on this issue that the Tax Court concluded that the IRS was not prejudiced or unfairly surprised, thereby letting him raise the issue that he did not flag in his petition.

I am a Professor at Villanova Law School, where I am the former Director of the Graduate Tax Program and the Law School's Low Income Taxpayer Clinic. Before I joined Villanova, I was an associate at Davis Polk & Wardwell and at Baker & McKenzie in New York and Londo...

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